Monday, February 07, 2005

5.5 Myths About Bubbles

Myth 1: Bubbles are rare aberrations to normal rational and efficient economic functioning.

Reality: Bubbles occur all the time. They are not aberrations to normal economic functioning. They are normal. Since the 1960s there has hardly been a year where a bubble has not occurred somewhere. Today, we swimming in bubbles see: China, hedge funds, real estate, US debt, nano-technology.

Myth 2: Bubbles are just “irrational exuberance” seizing the whole market.

Reality: Exuberance plays a role but its just one part of the story. There are both rational and irrational aspects to bubbles. They are based primarily on a cascade of bad investment decisions that follow some classic patterns throughout history fueled by 4 things: 1) distorted information and analysis that appears to justify inflated valuations for many; 2) distorted competitive marketplace that force everyone to play the game in order to earn competitive returns in a hot bubble market; 3) distorted allocation of capital that over-saturate investment opportunities; 4) easy access to money deteriorates sound business decision making leading to waste, bad business, lower return on capital and in the end a crash.

Myth 3: Bubbles are a big Ponzi scheme in which savvy investors take advantage of naïve investors who are consumed by enthusiasm and do not understand what their investments.

Reality: A lot of naïve investors do fall pray to savvy investors, but a lot of savvy investors get sucked in too. There are 3 types of investors regardless of how savvy they are: Believers, switchers and speculators. Believers truly have faith that they are making good investment decisions because they have a “vision” of the future of some new technology or market opportunity. Often the long-term potential of this vision is correct. What they tend to get wrong is how long it takes for this vision to become reality and where profits can actually be derived. As bubbles last for years, many investors switch from being skeptical and staying out of the market to investing. Some do this because they are converted and become believers. Others capitulate, they are forced to invest because in order to meet competitive returns in bubble markets they have to play the game. Speculators are timing the market and trying locate the fools who will hang on to inflated assets longer than they will.

Myth 4: Bubble are caused by excess liquidity driven by Federal Reserve policy that sets interest rates too low.

Reality: Liquidity is a key driver of bubbles, but interest rates are not always the primary source of liquidity for bubbles. Low interest rates can help provide a ripe capital market environment for bubbles and can tip the balance for some marginal investors to put in a little more money than they would otherwise. However, while low rates do lower risks of capital, they do not eliminate risk altogether. No interest rate justifies the kinds of bad investments that occurs during bubbles such as dot.coms that never should exist, Chinese companies that are scams, condo construction in super saturated markets like South Florida. Many bubbles occurred during rising interest rates including: The bubble leading to the 1987 crash, the Go-Go years of the 1960s, personal computers in the early 1980s. The primary source of liquidity for during many sector specific bubbles is investment portfolios targeting bubble assets that rise dramatically with the bubble, reinvest their gains creating self-perpetuating capital spiral that only ends when the bubble bursts. The more important cause of bubbles is not low rates, but a cascade of bad investment decision making.

Myth 5: Bubbles are bad.

Reality: Purely speculative bubbles like the Dutch Tulip mania, certain stocks, commodities, currency, don’t produce anything and typically crash leaving more people worse off. They are bad. However, business bubbles based on new technologies like the Internet or new market regions like China, are the driving force of capitalism. They finance innovation, change and accelerate learning about new opportunities.

Myth 5.5: Bubbles are good.

Reality: Speculative bubbles tend to leave more people worse off than when they started. Even productive business bubbles have great costs and carry great risks. The costs are obvious in the form of money lost during the crash. But the risks can also have sweeping effects in the US and global economy. The last 25 years has seen bubbles that have rocked the US or world economy (LDC Debt, S&L Crisis, Asian Miracle turned Asian Economic Crisis, Russian Debt Crisis, Long-Term Capital Management, Argentina, the Internet), each time nearly bringing the globe to an economic crisis.


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